Foreign Direct Investment Trends

February 2006

By Daniel Kah, Research Director

AngelouEconomics

Foreign direct investment (FDI) is the underlying driver of many key U.S. economic issues including offshoring, the trade deficit, job creation, the current account deficit, and even interest rates. FDI is a domestic firm investing in a foreign market and vice versa. A GE call center in India and Toyota truck plant in San Antonio are both FDI. Firms seeking to invest in foreign markets have two options: build from scratch, often called a greenfield investment, or invest in an existing operation through a merger or acquisition.

Firms invest in foreign markets for three reasons – to serve the local market, increase efficiency, or natural resource access.

Market seeking FDI is driven by access to local or regional markets. Investing locally can be driven by regulations or to save on operational costs such as transportation. General Motors’ investment in China is market seeking because the cars built in China are sold in China.

Efficiency seeking FDI is commonly described as offshoring, or investing in foreign markets to take advantage of a lower cost structure. A credit card company opening a call center in India to serve U.S. customers is a form of efficiency seeking FDI.

Resource seeking FDI is investment focused on extracting or refining natural resources such as petroleum, natural gas, or timber. The investment is seeking access to existing resources, such as Exxon Mobil investing in oil production in the North Sea.

FDI flows moved back to historical norms in 2004 after a few volatile post-bubble years. Investment peaked in ’99 and ‘00 with over $1 trillion invested both years, and while the $650 billion invested in 2004 is below these peak years, foreign investment remains higher than any year previous to 1999. Historically low interest rates and strong equity markets provide the necessary means to raise capital for new investment and cross border mergers and acquisitions. The United States returned to a leadership position as the world’s leading source of FDI and destination for FDI. Investor confidence continues to increase, especially with respect to the world’s strongest economies, those of the U.S., U.K., and China.

Foreign investment in Europe remains substantial but could decline as Europe’s largest economies continue to struggle with slow growth, increasing regulation, and long-term structural issues. Germany, France, Spain and the Netherlands suffered sharp contractions in FDI inflows, although impressive growth in inflows into the United Kingdom helped offset these declines.

China continues to attract record levels of investment from foreign multinationals. A country that attracted a negligible amount of foreign capital just 20 years ago was the world’s largest recipient of foreign direct investment in 2003, a title lost to the U.S. in 2004. Extensive infrastructure investment and an expanding real estate market continue to drive foreign investment, but the manufacturing industry still accounts for 70% of FDI.

Developing nations in general are attracting an increasing share of global FDI inflows. China is the most noteworthy, but FDI is growing in Brazil, Mexico, and many Eastern European countries.

The increasing price of a wide basket of natural resources, brought on in large part by the economic boom in China, has stoked resource-based investment. A case in point, Australia, with a diverse natural asset base, attracted more foreign investment in 2004 than France, Japan, and India combined.

India remains one of the most interesting countries to study. Foreign investment in India garners an enormous volume of press coverage, but the country attracts a pittance compared to China. India’s FDI is comparable to Romania and Argentina, not major global economies. The bright spot for the country is that investment does tend to be high value add, with a sizable export-oriented service sector.

Foreign-owned companies in the U.S. account for 5.3 million jobs, with 40% concentrated in the manufacturing sector. Foreign firms employ 5% of American workers and 12% of manufacturing jobs. Foreign investment in autos, aerospace, defense, and pharmaceutical manufacturing remains strong. Japanese, German, and Korean auto firms employ approximately 50,000 auto workers in the U.S.

In the United States, FDI trends vary among the states according to comparative advantages. Texas and California are the nation’s largest foreign investment destinations for new plants and equipment, although growth has declined for both.

States that aggressively recruit foreign investment see the dividends in investment and employment. Foreign investment accounts for more than 20% of manufacturing employment in a handful of states including Kentucky and South Carolina.

The fastest growing sources of international investment are in Asia, including China. China continues to accumulate significant amounts of foreign currency through its trade surplus and is beginning to re-invest those resources aboard.

On the other side of the issue is investment abroad by U.S. multinationals. Not only is the U.S. the world’s largest recipient of FDI, but it is also the largest supplier of foreign investment. American companies invested $229 billion abroad in 2004. Although offshoring receives the most attention, over 75% of this investment is directed at the local market. In 2002, only 11% of sales from U.S. corporate international operations were directed back to the U.S. Put another way, the large majority of U.S. investment abroad is not offshoring; rather, firms are pursuing revenue opportunities in other markets. The 11% of sales focused on the America market is still a significant number and has begun to affect the trade deficit. According to a recent McKinsey study, 32% of the U.S. trade deficit is created by American firms trading within the corporation. But that’s a story for another article.